Argumentation:ABCT

This highly experimental page is devoted to the attempt to create an argumentation chain for the Austrian Business Cycle Theory (ABCT). It is not intended to cover every possible angle, merely to build up one (or more) ways to explain ABCT. People may pick up any part in their own argumentation.

Business cycle as a historical fact

Entrepreneurs try to predict the future state of the market (consumer demand, prices of their inputs, etc.) and plan accordingly. Of course, sometimes they fail - that is only human and predicting the future is always hard.

What is known as the bust - a part of the business cycle - is not simply failure. It is a large number of failures, coming apart at the same time, coupled with a general downturn in economic activity. The bust is preceded by a boom - an increase in economic activity, often later perceived as unhealthy or speculative in nature. The regularly occurring booms and and busts were observed from approximately late eighteenth century.

Economic growth and the interest rate

Lowering of interest rate with increased savings

Interest rates coordinate investment and consumption across time. When interest rates come down naturally it is because people are saving more. Banks become flush with cash which causes them to lower rates to stimulate loans.

Entrepreneurs are receiving two signals from the market when this happens:

That new resources are available to make new investments.

That demand exists that is not currently being satisfied (people are forgoing purchases for the future).

When investment is made in this environment, there is, as always, the possibility of failure, but the investment is backed by actual saved resources and there is pent up consumer demand that can make it profitable upon completion.

The lower interest rate is also signal for consumers that there are more funds they can borrow and enjoy (providing they repay them, of course).

Monetary policy

Perfect creation of new money

Many economists claim that by creating new money out of nowhere increased aggregate spending power (or demand) can result.

Let's consider first an unrealistic scenario. An angel listens to the pleas of many people for more money and with magic doubles the amount of money everyone has (the Angel Gabriel model by David Hume). What would happen?

While everybody would be happy to have twice the money as before, nobody would be better off - there would be no increase in capital, productivity or goods. The only effect would be the (approximate) doubling of prices and the currency would lose half of its purchasing power.

If only some people get the money, the spending power is reallocated but not increased overall.

Creation of new money in reality

What if interest rates are brought down artificially, but not so obviously, for example by a central bank like the Federal Reserve? Entrepreneurs still receive and act upon the same economic signals, but no new investable resources exist to complete the new projects, and no pent up demand exists to justify their undertaking.

But the situation is much worse than that. The lower rates encourage people to take out what savings they have and spend it now. (And more consumers are encouraged to borrow and enjoy consumption.) As a result, actual demand will be even lower when the completed projects are ready to enter the market.

This is what is meant by malinvestment and overconsumption from changing interest rates. It creates an artificial boom in economic activity followed by a bust when the economy realizes the errors it made.

There is no free lunch. All of those rate cuts have to eventually be increased, at which point all of the stimulative forces reverse and the bad investments reveal themselves. The alternative to rate increases is continued inflation, which can only end in a collapse of the currency.

Consequences

The creation of new money out of thin air really creates what appears to be growth. Signaling, that more resources are available, businessmen invest, start new projects, employment rises, consumers enjoy more consumption, analytics rejoice.

This fake prosperity - also known as a boom - ends in a very real crisis - the bust. The wrong investments reveal, that many resources have been wasted on nonviable projects and produced goods the customers didn't want. Many projects cannot be completed at all. Unemployment will rise and the economy will suffer a crisis.

Counterarguments and Questions

But there were crises before the Fed!

The type of a crisis ABCT explains does not depend on the presence of a central bank. Money can be created "out of thin air" by other institutions (see e.g. the role of the Treasury in the Panic of 1907 or the Bank of the United States in the Panic of 1837).

However, there are also other phenomena that can expand the money supply - like Fractional reserve banking. Banks engaging in this practice keep only a fraction of their reserves on hand and lend the rest.

Does ABCT really explain everything?

The Austrian Business Cycle Theory does not claim to explain every single economic crisis. There are still wars and catastrophes, and there are particularly destructive government interventions, all of which can create a crisis.

The ABCT explains and describes a particular type of crisis, which seems to be unfortunately rather prevalent.

Are Austrians happy when a crisis breaks out?

In a word: No.

The Austrian theory of the business cycle is more accurately a theory of an unsustainable boom than a theory of a depression. And an unsustainable boom must collapse. The recession or depression that follows an artificial boom is not something to avoid but is essential to the alignment of consumer time preferences and the structure of production. Unemployment and failures of companies tend to be a part of this.

To put it metaphorically, suffering withdrawal symptoms won't be enjoyable for a drug addict, but it is the only way to get off drugs. Credit - or debt - has been the drug that has allowed people to consume more now than they can consume in the future. When the future arrives, those who borrowed need to adjust their spending down. But for those addicted to spending, they cannot stop without unbearable pain being inflicted. So they look for any justification to borrow more. For government bureaucrats that justification comes in the form of Keynesianism.

In another example (courtesy of Robert Wenzel), one cannot say that a heart surgeon attempting to save a man's life by heart surgery is in favor of pain as the way to save the man, even though pain is most assuredly a byproduct of a major heart operation. The call of Austrian economists for immediate liquidation of malinvestmnets is not becasue they are into pain, but because they understand that if liquidations don't take place now pain will be much more severe down the road. In this sense, Austrians offer the most sound treatment to limit pain.

Why don't the business people just ignore the boom?

Business people might be misled in the first couple of runs of the business cycle and not anticipate that the low interest rate will later be raised. Why do they continue to be unable to figure this out?

Every few years there is a fresh crop of naïve employers willing to borrow money and start new projects.

Businessmen and economists are more than happy to throw away old standards and wisdom and embrace the next boom (as shown in Reinhart and Rogoff's book This Time is Different).

Central banks often deliberate and choose monetary policy in secret. Businessmen aren’t always aware of changing policy and whether interest rates changes reflect increased savings on the part of the public.

Central banks can’t precisely control where newly created money flows into - neither can business people make the same calculations to know what sectors are being manipulated.

Even if entrepreneurs understand the ABCT, they cannot predict the exact features of the next cyclical expansion and contraction. They lack the ability to make micro-predictions, even though they can predict the general sequence of events that will occur.

The entrepreneur must not only understand the consequences of years of past interventions, he must also predict what the central bank will do in the future and when it will do it — all while the central bank tries to anticipate what the entrepreneurs will do. Such an entrepreneur will probably have little time for things such as serving his customers, improving his product and responding to his customers’ preferences.

Some companies would knowingly borrow at the below-market rates and take the risks associated with the loans, typically those that were undercapitalized, perhaps startups or companies in trouble. In short, they would be the companies that had nothing to lose.

Entrepreneurs who know a boom is underway are powerless to prevent their more reckless competitors from taking cheap (or free) government loans and bidding away scarce resources. Workers don't care whether their paychecks come from genuine saving or from the Fed's printing press. Companies can lose ground to competitors who take the easy money and use it while it is non-neutral. Some have described it as a prisoner's dilemma situation.

Finally, there are profits to be made from exploiting temporary situations. The entrepreneurs have no reason to ignore the temporary profits to be garnered in an inflationary episode. Time necessarily plays a role in the formation and eventual popping of market bubbles - it can take literally years. Even if the majority of the market agrees that, say, internet stocks are way overbought, there may still exist a chance to buy in and ride the wave before cashing out.

Why is there even unemployment?

In the beginning, an investment boom gets out of hand. Whatever the reason, all that investment leads to the creation of too much capacity. Eventually, however, reality strikes—investors go bust and investment spending collapses. But, why should the ups and downs of investment demand lead to ups and downs in the economy as a whole? As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment? According to the Austrians, mass unemployment was part of the process of "adapting the structure of production." But in that case, why doesn't the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment?

At the beginning of the boom, when a central bank pumps in new money, new demand is created for labor in the capital goods sector causing bidding for labor away from the consumer goods sector. People switch from their existing jobs for more lucrative ones: thus, there is no point where rising unemployment would be a factor in this part of the cycle.

However, during the downturn part of the cycle, it is not a case that the central bank is pumping money into the consumer sector. What is occurring, instead, is that a transfer of money is taking place from the capital goods sector to the consumer goods sector. It is this money drain from the capital goods sector that causes the unemployment. People are being fired and need time to find new jobs. Also, a lot of money was wasted during the boom and is simply lost.

Also, in a recession, every industry — not just the investment sector — normally contracts. The problem in the aftermath of a bubble isn't merely that a "given" level of demand switches from one sector to another. On the contrary, people in general are poorer than they thought they were at the height of the boom. In particular, during the boom, people unwittingly consumed capital.

Example

Imagine an economy with just one actor: Robinson Crusoe on an island. Crusoe loves fish, so he spends half of each day fishing so he can enjoy fish in the evenings. Additionally, Crusoe spends one day mornings maintaining his fishing dinghy and nets. In order to have fish on that day, he must fish for an extra hour every other day of the week. In economic terms, Crusoe has a savings rate of one hour per day. His savings rate is also his investment rate, or the percentage of present income he sets aside to maintain or increase future consumption.

Crusoe doesn’t have a fridge, so he preserves his catch by throwing it in a small, dark pond. He can’t see how many fish are in the pond, so he keeps a stack of small rocks near it. Every time he adds a fish, he adds a rock, and every time he eats one, he removes one. The rocks are his money supply.

Suppose that Crusoe shares the island with some mischievous monkeys, who see Crusoe adding rocks to his pile. They decide to imitate him, so every time Crusoe ads a rock, they sneak in and add one as well. The monkeys are inflating the money supply by injecting currency into Crusoe’s investment fund.

One day, Crusoe suddenly notices that his "savings rate" of fish is larger than he thought - double the usual. He concludes that he really is a great fisher and saver and decides to take a day off each week, eating some of the fish he caught before. This is the consumption-side of the boom phase of the business cycle. Crusoe also decides to take some extra time each day to start building himself a new hut. This is the investment-side of the boom phase of the business cycle.

Crusoe now believes that the cost of saving fish is half the usual, while in fact his savings rate is too low for the investments he is planning.

And one beautiful day, when it comes time to eat his midday meal, Crusoe suddenly realizes that he’s out of fish – despite having a surplus of rocks. He’s exhausted his investment capital because the additional currency snuck into his money supply did not represent a real increase in his productivity or savings rate. He doesn’t have the capital (fish) to maintain his previous consumption rate, much less increase it. He is forced to cut his investment rate (he must spend some of his day off fishing) just to have some fish for dinner. He must also abandon his incomplete hut because he does not have the time to finish it. The abandoned hut is an extravagant expenditure that represents a loss of capital. This is the bust phase of the business cycle.

To review, here’s the overall impact of the monkey’s trickery: Crusoe catches the same number of fish, but consumes more and invests more, and therefore saves less. That’s the boom period. Then, Crusoe has to consume less fish, and spend less time for maintaining his nets (capital). Some of his investment/consumption time must now be spent in production. That’s the bust period. If Crusoe’s initial savings rate allows him to just break even each week, his nets will gradually get worse and worse and he will eventually go hungry.